The Law of Unintended Consequences

Don Alexander
RSD Solutions Inc.
NYU
SunySB

“This long run is a misleading guide to current affairs.
In the long run we are all dead”.

John Maynard Keynes

Central banks have embarked upon one of the greatest economic experiments of all time ‐ ultra easy monetary policy. In the aftermath of the economic and financial crisis which began in the summer of 2007, they lowered policy rates effectively to the zero lower bound (ZLB). In addition, they took various actions which not only caused their balance sheets to swell enormously, but also increased the riskiness of the assets they chose to purchase as well as creating long-term risks that are not fully understood.

William White, in a recent paper, Ultra Easy Monetary Policy and the Law of Unintended Consequences (Dallas Fed WP 126, Sept. 2012) evaluates the cost-benefit analysis of ultra-easy monetary policy by weighing the balance of the desirable short run effects and the undesirable longer run effects – the unintended consequences. 

The case for ultra-easy monetary policies is well known to convince the central banks of most AMEs (advanced market economies) to follow such polices. They have succeeded in avoiding a collapse of both the global economy and the financial system.

Nevertheless, White argues, that the capacity of such policies to stimulate “strong, sustainable and balanced growth” is limited. Moreover, ultra easy monetary policies create medium term effects ‐ the unintended consequences.  Hence the view, central banks have limited options.  One reason for believing this is that monetary stimulus, operating through traditional channels, might be less effective in stimulating aggregate demand. Further, cumulative effects provide negative feedback mechanisms that over time may distort traditional supply and demand relationships.

These policies may create real economy investment distortions, threaten the health of financial institutions and the functioning of financial markets, constrain the “independent” pursuit of price stability by central banks, encourage governments to refrain from confronting sovereign debt problems in a timely manner, and can regressively distort income/wealth.  The medium term effects can be questioned, considered together, they support strongly that aggressive monetary easing in downturns is not “a free lunch”.

When this crisis is over, the principal lesson for central banks is they should lean more aggressively against credit driven upswings, and prepare to tolerate the subsequent downswings helping avoid future crises of the current sort.  The current crisis is not yet over, and the principal lesson to be drawn from this paper concerns governments rather more than central banks.  Central banks have bought time to allow governments to follow the policies likely to lead to a resumption of “strong, sustainable and balanced “global growth. If governments do not use this time wisely, then the ongoing economic and financial crisis can only worsen as the unintended consequences of current monetary policies increasingly materialize. 

http://www.dallasfed.org/assets/documents/institute/wpapers/2012/0126.pdf